Writing in Alberta Oil Magazine, MLI Managing Director Brian Lee Crowley makes the case for why developing natural resources creates more value for the Canadian economy than manufacturing.

He argues that many products generate wealth during the design and distribution, rather than production, stages of the development process, which should raise natural resources like bitumen or copper to a prominent place of importance for the economy.

This, he says, runs “contrary to the widespread assumptions of economic nationalists who belittle the hewing of wood and the drawing of water as beneath the aspirations of serious nations, who should pursue manufacturing and other forms of processing at all costs”.

Brian Lee Crowley, June 3, 2014

IPods and oil refining are two subjects that, on the surface, could hardly be more different. Yet iPods offer a wonderful object lesson in understanding where the real value lies in the various stages of moving an idea from concept, through design, manufacturing, marketing, distribution and other stages until the final product ends up in the hands of the consumer.

And Canadians need to have a rather similar insight if we are to get maximum value out of our petroleum resources.

In the early ’90s, Stanley Shih, the head of Taiwanese computer company ACER, pointed out that the highest value-added parts of the production of IT equipment resided at the two ends of the production process. A huge amount of value (relative to costs) was created by the brand built by the company and the conception and design of the equipment at the very beginning of the process. Similarly big value was created in the distribution, wholesaling and retailing of final products to consumers. In between, things like R&D (the turning of design into practical plans) and marketing created less value than the others, but were still relatively well-rewarded.

The stage that added the least value was taking the plans and turning them into an actual product; in other words, the manufacturing. If you plot these things on a graph, it makes a smile-shaped curve, with high-value activities at either end high up on the graph, but the manufacturing far below the two in the middle. This is known as the “smiley curve.”

This principle was explored in a notable 2007 article by Richard McCormack looking at the iPod: “Not much of Apple’s iPod is manufactured in the United States, but the majority of value added is captured by Apple … Apple made $80 in gross profit on a 30-gigabyte video iPod that retails for $299. Its profit is 36 percent of the estimated wholesale price of $224.”

Hold that thought: Apple doesn’t manufacture the iPod, but contracts out that small and relatively unprofitable part of the process to Chinese manufacturers. That doesn’t impoverish Apple.

It helps to make it one of the world’s richest companies. And America is made richer, not poorer, by this behavior because it means that Apple concentrates its efforts where the money is, and leaves low-value manufacturing to others.

Perhaps surprisingly, this concept is quite transferrable to the natural resource economy, contrary to the widespread assumptions of economic nationalists who belittle the hewing of wood and the drawing of water as beneath the aspirations of serious nations, who should pursue manufacturing and other forms of processing at all costs.

We’ve all heard the rhetoric about how Canada shouldn’t export timber or bitumen or copper, but should somehow keep it home and “add value” to it. A recent article in the National Post quoted a Northern Gateway opponent in Kitimat as saying that exporting raw bitumen meant exporting “thousands” of Alberta refinery jobs.

But substitute “refined oil products” for “iPods” and the smiley curve applies just as much here as it does to IT, as a recent report by University of Calgary professor Trevor Tombe showed. One of the reasons that manufacturing (including a lot of processing like upgrading and refining) has such poor margins is because it is fully globalized. If you want to assemble iPods in Canada, you can of course do so, but you have to be willing to do it at Chinese or Vietnamese or Indonesian wages.

The value of bitumen (especially once the bottlenecks in the pipeline system are resolved), however, isn’t governed by developing world wages but by world commodity prices. Oil is valuable, and we have one of the world’s largest supplies. We make more money producing it than we do refining it – a lot more. Moreover, extracting the bitumen is a process that by definition must occur here; it cannot be outsourced, unlike refining, where you are in competition with huge, brand new, efficient refineries close to final markets in Asia.

So in a world where we cannot do everything, where we have to make choices about where our workers and capital are best employed to provide the highest standard of living for Canadians, does it make sense to force producers to process the bitumen at home? No. Every choice to divert scarce workers from bitumen extraction, for example, is a choice to take them from a high value-added activity at the top of the smiley curve and move them to the bottom, where they add the least value. That would be no reason to smile.

Brian Lee Crowley is the managing director of the Macdonald-Laurier Institute, an independent non-partisan public policy think-tank in Ottawa

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